Options on Futures: Familiar Ground … Sort Of

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By
Thomas Preston

October 1, 2012

Fredrik Broden

Options. Futures. Options on futures. Derivatives on derivatives. Exponential permutations and combinations that threaten to strike fear into our hearts...and stuff that sounds eerily like what nearly killed the economy back in 2008. Wasn't it derivatives on derivatives that has so far cost JP Morgan a few billion?

Rest assured, the products themselves don't kill you. It's generally how they're used. To wit: options on futures are pretty similar to the options you use to sell covered calls against your long stock. And they're the only way to establish positions with lower risk and lower capital requirements in certain markets—like physical commodities that don't have another product, such as an index or fund that tracks them. If you get to know how futures options work, you can use them to expand your universe of trading opportunities. Don't let the words scare you off. Read on and decide for yourself if you're ready to incorporate futures options into your portfolio.

Not Your Father's Options

Buying an option gives you the right to buy (in the case of a call), or sell (in the case of a put), an underlying security at the strike price of the option. That should be pretty familiar to most people who've traded an option on a stock. That's how a future option works, too. If you buy a call option on corn futures, that gives you the right to buy a corn future at the strike price of the call. But a few nuances make futures options a little unlike stock options. And these nuances don't necessarily make it harder to trade them, but you should be familiar with the twists and turns before you start trading options on futures.

1— WHAT YOU GET. This is the simplest. What does a future option deliver when you exercise it, or it's assigned?

A future option delivers one futures contract. So, let's use options on the E-mini S&P 500 future as an example. If you exercise a call option on the E-mini S&P 500 future, you'll be long one E-mini S&P 500 future. If you exercise a put option on the E-mini S&P 500 future, you'll be short one E-mini S&P 500 future. If you exercise a call option on soybean futures, you'll be long one soybean future. You won't have 5,000 bushels of soybeans in your driveway. That's why the price of the future option is driven by the price of the future that it delivers on exercise, not the “spot” price, like the SPX S&P 500 cash index, or a bushel of soybeans.

But unlike a stock option that always delivers 100 shares of the same stock, a future option delivers the future that expires at the same time, or later.

Futures have expiration dates. So you can't have an option that delivers a future that's already expired. For example, an October expiration option on the E-mini S&P500 future delivers a December E-mini future. So does a November and December expiration option. But a January expiration option on the E-mini S&P 500 delivers a March E-mini future. This is important because futures prices on the same index or commodity can have different prices in different expirations, and can move with either greater or lower volatility than a future in a different expiration. In grains, for example, planting is done in the spring and harvesting in the fall. Futures that expire in March through September are termed “old” crop, because they would deliver grain harvested the previous fall. Futures expiring in November and December deliver grain that's just been harvested. Old crop vs. new crop futures can have different price changes. Options on futures will change in price according to the changes in the future that the options deliver.

2— POINT VALUE AND TICK SIZE. A standard equity option has a point value of $100, and changes in either .01 or .05 increments, with each .01 increment worth $1.00. That is, if a call on a stock goes from 2.50 to 3.50, its value has increased $100. After a 3:2 stock split, the options have a point value of $150, but that's about as complicated as they get. The point value of futures options isn't standardized. For example, one point in an E-mini S&P 500 future option is worth $50, and the minimum increment is .25, which is worth $12.50. One point in a bond future option is worth $1,000, and the minimum increment is 1/64th, which is worth $15.625. And one point in a corn future option is worth $50, just like the E-mini S&P option, but the minimum increment is 1/8th or .125, worth $6.25.

Before you trade them, get familiar with the point value of the future option you like (which you can get at the website of the Chicago Mercantile Exchange). Risk management starts at order entry, and the dollars you put at risk on a trade depend on the options’ point values. Also, you can calculate the amount of slippage, or the difference in dollar value, between an option's bid and ask prices. A bid/ask spread of .50 in an E-mini S&P 500 option is worth $25. But a bid/ask spread of four ticks on a bond option is worth $62.50.

3— EXPIRATION. Stock options almost always expire on the Saturday after the third Friday of the month. As a stock option trader, that's handy for planning vacations. But, futures options don't always give you that freedom. The E-mini S&P 500 future options expire at the same date as the equity options. They were designed as a hedge for equity, and to make equity options portfolios easier.

But bond future options have some funky expirations. They expire on the last Friday that precedes the last business day of the month preceding the option month by at least two business days. Huh? September bond future options expire in August. December bond future options expire in November. Crude oil-futures options expire three days before the end of trading of the corresponding future, which expires in the month before the future expiration month, to accommodate delivery of crude oil. Double huh, right? Make it easy on yourself and look on the left-hand side of the Trade page of TD Ameritrade's thinkorswim® platform, for the number of days until the last trading day of the options. It's the number in parentheses after the expiration month. This will help you not get surprised by expiration.

Back to the Future(s)

That's pretty much it for the differences. Now let's dip into some of the most actively traded futures. Futures, future options, and index options work together in the S&P 500. You have the SPX, SPX options, E-mini S&P 500 futures, and E-Mini options, all based on the S&P 500, right? Well, sorta.

S&P 500 index (SPX). The SPX is the index based on the composite value of the 500 stocks in the S&P 500. You can't buy or sell the SPX itself. But it can drive the value of the E-mini S&P 500 futures, based on an arbitrage relationship between the interest cost and dividends on the 500 stocks, and the expiration of the future. So, SPX moves up, and E-mini S&P 500 futures move up. But sometimes the E-mini S&P 500 futures move up quicker, or more, than the SPX. (For more on futures trading, see our Futures Special Focus in thinkMoney .)

You also have SPX options, which are cash-settled options that deliver the cash difference between the strike price and the SPX. You'd think SPX options are priced off of the SPX, but you'd be wrong. Why? SPX option traders can't trade the S&P 500 stocks any easier than you can. So they typically use E-mini S&P 500 futures as their hedge. When the hedge moves, the options move. SPX option market makers factor the cost of carry and dividends out of the E-mini S&P 500 future, and use that to come up with the prices of the SPX options. Fun, no?

Options on the E-mini S&P 500 future do, too. The difference between E-mini and SPX options is that the E-mini S&P 500 futures options deliver the future, not cash. They don't need to factor in the cost of carry and dividends of the SPX. So, both SPX options and E-mini S&P 500 futures options are valued off the E-mini S&P 500 future.

Don't confuse SPX options with E-mini S&P 500 futures options. An S&P 500 future option is an American-style option, meaning a long option can be exercised at any time between the time it's purchased through expiration, and its futures settled. This means if you exercise a long S&P 500 futures call, you'll take delivery of one S&P 500 future. SPX options are cash-settled, and European-style. Importantly, one point in the E-mini S&P 500 future option is worth $50. But one point in an SPX option is worth $100.

Picking Favorites

So, which is better—SPX options, or E-mini S&P 500 futures options? It's not a question of the best product. But, how best to use the product.

Let's look at the pros and cons of using them as a way to potentially enhance a $100,000 stock portfolio's returns. Selling an out-of-the-money call vertical is a strategy that could be used in this way. With the SPX at 1362, a short 1390/1400 call vertical with 28 days to expiration is worth about $3.10. If we sell 10 of them, the maximum potential risk is $6,900, if the SPX is above 1400 at expiration. The potential enhancement to the portfolio would be $3,100, if the SPX is below 1390. (Breakeven on the SPX is $1393.10.) SPX options have the widest bid/ask differential, meaning slippage is potentially higher. But you can execute the SPX vertical, and the execution price would be $2.90, making the maximum potential risk $7,100, and the potential return $2,900. (Break even on the SPX is $1392.90.)

Finally, with the E-mini S&P 500 future at 1,362, the 1390/1400 call spread with 28 days to expiration is worth $3.25. To get an equivalent amount of risk and reward to the SPX verticals, we'd have to sell 20 of the E-mini future option spreads with a maximum potential loss of $6,750, if the E-mini S&P 500 future is above 1400, and a potential enhancement of $3,250, if the future is below 1390 at expiration. (Breakeven on the E-mini future is $1393.25.) Factoring in slippage of one tick, or .25, the net price of the spread might be $3.00, which would give it a maximum potential loss of $7,000, and an enhancement of $3,000. (Breakeven on the E-mini future is $1393.00.) With E-mini S&P future options, commissions could be two times higher than with SPX options. But that could be offset by lower slippage. In this case, whether you use SPX options or E-mini S&P 500 options depends on the size of your portfolio, as well as your ability to work your orders in between the bid/ask to get better pricing.

Now that you've learned some of the basics about futures options, consider testing them out in paperMoney®, found on the thinkorswim® trading platform. Or if you are ready to incorporate them into your portfolio, you can apply for a futures account to trade them alongside your stocks and stock options.

How to…Trade options on futures in thinkorswim

If you're already trading equity options, you're half way there

FIGURE 1: Futures Options trading on thinkorswim is pretty much like trading equity options. You can place a trade in about three steps (read the article), but bear in mind, you have to have a futures account (see sidebar, page 36). For illustrative purposes only.

Got the option trading blues when equity markets close at 4pm ET each day? What if you could trade 24 hours per day? You can—in the futures options market. Yup, 24 hours a day, 5.5 days a week, you can trade E-mini S&P and E-mini Nasdaq, as well as crude oil, gold, corn, the euro currency, and many more. Just be sure to check the trading hours at tdameritrade.com. They all have their own trading hours, which can differ.

Now, if you come from the equity options world, the notion of trading a derivative of a derivative might make you a little uneasy. But don't worry. Trading options on futures isn't that different than trading equity options. The same basic concepts—option greeks, time value, strike price, and most of the strategies you can do with equity options—also apply to futures options. And if you're already using the thinkorswim trading platform for your equity options trading, you're probably familiar with how to place trades on futures options. You just follow the same three steps:

1- Select your underlying futures product. Choose a product like the E-mini S&P (/ES) under the main Trade tab. This will display the active month under the FUTURES section.

2- Expand the OPTION CHAIN section. By expanding this section, you can view the strike prices by month. In addition, you have access to the same great options tools you use when trading equity options. For example, you can increase the number of strikes you can view per contract, and, view different spread order types (i.e. Single, Vertical, etc), or customize your layout to show things like implied volatility, option greeks, volume, and open interest.

3- Confirm and send your order. Take one last moment to review your order to ensure the contract, strike price, and quantity are what you wanted. If so, simply click the Confirm and Send button. If not, you can either delete the order or adjust the order in the Order Entry window.

A nice perk of using the thinkorswim platform is that you can trade multiple asset classes from the same platform, with the same look or feel, using the same log in. But before you jump off the starting block, take advantage of the education available to you to be aware of all the important nuances. Knowing things like the correct trading hours of the underlying futures product, as well as each of their respective price increments, could make a huge difference in your profit/loss if you're not paying attention.

Now, if you have a burning question about how to trade options on futures, you can always reach out to our futures Trade Desk. Click on the Support/Chat button in thinkorswim to contact a futures Trade Desk representative via Live Support, or just enter one of the Chat Rooms. If you'd rather speak to a human (gasp), call us at (866) 839-1100 and we'll answer your question live.

You can learn more about options on futures by going to the CME's Options Education Center. In addition, TD Ameritrade's education affiliate, Investools, offers a variety of educational seminars to help educate you about options trading.

Need to open a futures account?

The process is completed in three easy steps:

1 You need to have Level 3 options approval prior to filling out the futures appli cation. To apply for Level 3 options, log in to the TD Ameri trade website, click on My Profile and click Edit Option Trading. Complete and submit the Upgrade form.

2 After receiving your approval,log back in. Under My Profile, click on Upgrade your futures account for futures and forex. Complete the “Upgrade Agreement for Futures and Forex.”

3 Once your account has been upgraded, (which may take about a day or two) go back under My Profile and click the Futures Apply button. Fill outtheonline futures application and you're on your way to trad ing futures.

The risk of loss in trading futures and options on futures can be substantial. Multiple-leg

Multiple-leg options strategies such as those discussed in this article can entail substantial transaction costs, including multiple commissions, which may impact any potential return. Be aware that assignment on short option strategies discussed in this article could lead to unwanted long or short positions on the underlying security.

Investools® does not provide financial advice and is not in the business of transacting trades. Investools, Inc., and TD Ameritrade, Inc., are separate but affiliated companies that are not responsible for each other's services or policies.

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

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